Finding Your Break Even Point - Engine Builder Magazine

Finding Your Break Even Point

Why should you care what your business’ break-even point is? What purpose does it serve to know what it is? More specifically, how do you determine which of your business costs are fixed and which are variable? What costs affect your break-even point the most? How often should this information be calculated? How do you use this information to better manage your business?

These are some of the questions that need to be answered in order for you to have a better understanding of the importance of knowing your break-even point. Let’s first explore the basic question of why you need to know your break-even point.

Actually, the reason you should care about it is glaringly obvious. The definition of break-even is “the point at which your revenues exactly equal your expenses.” Or, put in another way, “the company has neither generated a profit nor sustained a loss.”

This is one reason why you should want to know what the break-even point of your business is. It can tell you how much revenue you need to generate each day, or each month to pay the bills. It can help you determine if you should purchase that new piece of equipment. It can tell you the very first moment at which you even have a chance of making a profit.

Every shop owner must cover all of the fixed costs, and usually a certain amount of variable costs, before having the opportunity to make a profit. Let’s look at an example of a business situation where knowing your break-even point is helpful.

Say it is the peak sales time of the year. Your sales this month start out with a bang, just as expected. However, only one week into what should be the biggest month of the year, sales drop off drastically. You look for an explanation, any explanation, but none is found. All that you can tell is that the slow down seems to have affected everyone in the same business in your marketing area.

This may console you a little, i.e., misery loves company. But it doesn’t help with the fact that you still have “X” amount of expenses that you must cover, no matter what the sales volume is.

One purpose of knowing your break-even point is to be able to know when you have generated enough revenue to cover your expenses. If you do not generate enough revenue to cover expenses each and every month of the year, then you need to look at your fixed costs. Your fixed costs may possibly be too high to support the gross revenue you generate.

Variable cost importance

In addition to knowing your fixed costs, you should have a good understanding of your company’s variable costs. You need the flexibility in your variable costs to sustain profitability during both the slower sales months as well as during the higher sales months. In order to achieve this flexibility you must define your fixed and variable expenses. Fixed costs are rigid or preset, they remain constant regardless of sales. Variable costs are those costs which you can drive or affect from day-to-day. They are costs directly associated with selling your products or services.

Variable costs typically go up as you add more products or services what you offer. However, you have no real control over fixed costs; they are what they are. Variable costs you do have some control over; you can reduce the expenditure for them or eliminate them completely.

There is no perfect classification system for defining fixed and variable costs. Let’s look at an example, electricity, which makes that more understandable. What is the “minimum use” electric bill you would get from the local power company if you didn’t even open your doors this month? (For our company it would be about $50.) Then compare this amount to the electrical bill you typically pay in a month. (For me, this is about $800.) In this example, I might place $50 in fixed expenses for electricity use, and $750 in the variable expenses for electricity use.

Another way to classify electricity use would be to place all utility expenses under fixed costs. You see, you can spend the time necessary to split out these types of expenses between fixed and variable costs, or you can lump them all together. But whatever you do, as long as you consistently apply the definition, either way will work. You’ll end up with the important information you need to establish your break-even point.

After using break-even point analysis a few times, you may decide to look more closely at each type of expense. You may decide to record each expense more precisely as you get used to calculating it. And this is one of the objectives of knowing your break-even point, i.e., to scrutinize each expense you have so as to increase your overall profits.

You can, for example, choose to discontinue the uniform service expenses you provide each employee, in essence turning this into a variable expense. However, if you have signed a contract with a uniform service company for the next 12 months, this expense would become a fixed cost.

An item that might have some controversy as to how it should be listed in your calculations is depreciation expenses. Many say that you should use this line item found on your income statement as a fixed expense in calculating your break-even point. However, I disagree. I recommend that you use the actual principle and interest payments in the calculation as a fixed cost.

Remember, the income statement is a valuable financial tool. However, it is geared toward the collection of taxes from your company by the government. You did not spend the allowance for depreciation that is listed on the income statement. It is a figure that the government is allowing you to list as an expense.

It is likely that you actually spent more for the plant and equipment, especially when you add in principle payments. If you use the figure listed on the income statement for depreciation as a fixed cost, you will have defeated your purpose of calculating the real break-even point. You need to know in actual dollars what the amount of revenue you must generate to break-even is. So let’s use the actual amount that we are spending for both principle and interest.

The fixed expenses portion of your calculation will have the biggest impact on the amount of revenue which you must generate each month. This is the hardest one to control also. The local government can raise your real estate taxes, virtually at anytime, and you must pay them.

Your choices in the above example would be to protest the tax amount with the local taxing body, perhaps hiring an attorney to do this for you. Or another option would be to relocate your business to a lower taxing area. Neither option is easy, but both must be considered if you are to lower your fixed costs. One benefit of knowing your break-even point is to actually put a number, a dollar amount, on what you must generate per day or per month. This is tremendously beneficial information.

You then have more of the needed information to monitor your business and your employees. It can help you to determine if you are overstaffed or understaffed. It can help with the knowledge of what minimum amount of revenue you will need to generate if you purchase that new piece of equipment.

It can also help you justify the decision to hire another employee. It can help you to know, in advance, if it is more profitable to purchase cylinder heads from an existing vendor or to buy the equipment necessary to rebuild them yourself. Keep in mind that if your company is not growing or if your company is downsizing because of the local economy

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